Paper Pushers

The post-summer driving season is usually a forgiving time at the pump. But this year there was a detour on the road to lower year-end gas prices, which instead hit a record average high of over $3 a gallon. On Nov. 15, just a few days before oil surged to almost $100 a barrel, the headline on a wire story read, “Gas hitting record highs for holiday travel.” On that same day, another seemingly unrelated headline read, “Fed makes biggest temporary injection since ’01.” Coincidence?

As the price of oil has marched higher during the past few years, the media has latched on to various one-time or “temporary” explanations: unrest in Nigeria, refinery problems in Texas, weather in the North Sea, pipeline disruptions in Iraq. Just before tensions boiled over along the Turkish-Kurd border in mid-October, oil was trading at $80. News reports cited a potential military incursion by Turkey as the reason for oil’s subsequent rise. That incursion still hadn’t happened by early November, but oil was $96. “Strong demand” is another oft cited excuse, and this one has more merit. There’s no doubt that global growth and its impact on the supply/ demand ratio is an important factor. But during the last few years, and with increasing velocity, the rise in price has far outpaced demand. Between January and November 2007, the price of oil surged 92 percent. Those storms in the North Sea must have been pretty bad.

It’s only recently that another explanation has started to appear, albeit mostly as an afterthought near the bottom of news reports: the weak dollar. This is not an easy storyline for the mainstream media. Most people don’t—and don’t want to—understand the relationship between the price at the pump and the value of what’s in their wallets.

The word “liquidity” entered public discourse this year when problems in the subprime housing market surfaced during the summer. Liquidity can mean different things. Essentially, it’s the byproduct of daily Federal Reserve operations that maintain short-term interest rates. To prevent rates from rising above its announced target level, the Fed pumps money into the financial system.

So on a day-to-day basis, liquidity is the tool of a broader interest-rate policy. The two go hand in hand. But liquidity is powerful, and its effects don’t stop there. Nor do the Fed’s ambitions. One doesn’t need indicators like oil, the dollar, or gold. Wallets tell the story best.

Assumptions about the natural business cycle are part of the dollar’s intrinsic value. Ideally, investors expect that when the cycle slows, as the housing market has recently, the dollars accumulated during a strong economy will be worth at least as much, and likely more, when the economy weakens. This is the practical economic dynamic behind the folksy wisdom of “saving something for a rainy day.” But it can work in reverse. An important part of inflation is expectations. If investors believe the Federal Reserve will fight economic softness too aggressively, and in the process debase the currency, then the dollar loses both face and intrinsic value.

When this happens, it’s noticeable at the gas pump because oil is priced in dollars. But that’s only one manifestation of Fed policy. The price of oil also shows up in food, clothing, building materials, highway tolls, and mass-transit fares—things everyone knows cost more these days. The government understates inflation in several ways, one of which is stripping out the cost of those daily necessities to arrive at a “core consumer price index.” But it’s impossible to strip out inflation’s dangerous consequences.

There aren’t many historical examples of advanced, industrialized nations relying on a combustible mix of debt and fiat money to the extent the U.S. does. Argentina is one, as well as Germany during the early 1920s.

As Germany struggled to pay war debts and boost its industrial sector, it churned out a deluge of paper money. It was a deliberate policy, openly supported by prominent German business leaders like Hugo Stinnes, who ran the equivalent of a Dow Jones-listed company. Rudolph Havenstein, head of Germany’s central bank, boasted about the efficiency of his printing presses. German society felt the effects at every level. At the same time a pensioner needed a stack of paper money to buy a cup of coffee, the stock market and the economy soared. In his book When Money Dies, Adam Fergusson quotes from the letters of a private citizen:

Speculation on the stock exchange has spread to all ranks of the population and shares rise like air
balloons to limitless heights. My banker congratulates me on every new rise, but he does not dispel the secret uneasiness which my growing wealth arouses in me … it already amounts to millions.

And from a foreigner in the country on business:

The greatest fraudulent conspiracy in the history of the world is now being enacted in Germany with the full concurrence and active support of its 60 or 70 millions of people. Germany is teeming with wealth. She is humming like a beehive. The comfort and prosperity of her people absolutely astound me. Poverty is practically non-existent. And yet this is the country that is determined she will not pay her debts. … They are a nation of actors. … If it wasn’t for the fact that the German is guiltless of humor, one might imagine the whole nation was bent on perpetrating an elaborately laborious practical joke.

Sound familiar? Inflation “worked.” It was the fuel that created the veneer of prosperity. And it worked most of all for the banks and brokerages that sprouted on every corner, the 20-year-old stock traders, and those who had the savvy and means to protect themselves through hard assets—today’s investment bankers, hedge-fund managers, and speculators. To be sure, Germany in the early ’20s was an outlier, an extreme example of monetary policy gone awry. But some aspects of our current financial system have very few historical parallels, and that is one of them. It would be foolish to ignore it simply because so much about that era is easily dismissed for its madness.

Asset prices, then, can rise despite deadly underlying weakness. Part of the script for today’s financial pundits is the claim that all is well because the equity markets, though bumpy, generally were at or near all-time or multiyear highs for most of 2007. After the Dow plunged 237 points on Nov. 26, CNBC reported, “Alert: Dow +2.3% year-to-date.”

If that’s the standard, then it appears all is well. And that’s crucial. There’s a lot at stake: the Bush fiscal policy must work—or at least appear to. If it doesn’t, it will be discredited for a generation or longer, with obvious implications for elections and therefore income and capital-gains taxes.

Thus the pressure on policymakers to take extraordinary measures. After the late-’90s tech bubble burst, the Federal Reserve decided there was never a good time for economic weakness, much less recession. But a basic truism of the financial markets is that there’s no free lunch. Periodic recessions cleanse malinvestment and overcapacity. When government believes it has the ability to repeal the natural business cycle, eventually bad things happen.

To keep up appearances, policymakers need to do whatever’s necessary to avoid them. And that’s what the Fed has done, first by lowering interest rates to a rock-bottom 1 percent and inducing a real-estate bubble in the process, then by responding to every bump in the road with either lower rates or stock market-friendly comments. The financial markets understand political expediency. On Nov. 6, the Fed funds futures suggested a 62 percent chance of a rate cut in December. One day later, after the Dow plunged 360 points, the futures implied that a cut was a near certainty.

The Dow is composed of only a handful of companies, but there’s no more important barometer of public psychology. The behavior of that small group of stocks can paper over a lot of distress under the surface. So what happens if that barometer starts to fall and interest-rate policy, a blunt tool that works with a lag, isn’t enough? The possibility of direct intervention in the stock market has been the subject of much debate in the financial community. Some believe that the government—either the Federal Reserve, the Treasury, or a proxy—has intervened in the past to prop up the stock market. If that’s indeed the case, a national debate about it should take place. Government-sanctioned intervention in the stock market would have serious implications, including the use of public money to buy stocks while corporate insiders are selling, select Wall Street trading desks profiting from knowledge of the intervention, and the ability to boost the market prior to an election or other event. We know from the past few years that much can be justified when a nation is “at war.”

The upshot? Moral hazard. Reckless risk-taking is encouraged because the public believes the government will act as a backstop. On Milton Friedman’s 90th birthday in 2002, Ben Bernanke, then a Federal Reserve governor, honored the aged economist with a promise: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” He’s done his best to keep that promise.

To be sure, it’s important that policymakers encourage risk to some degree. Risk is crucial to capitalism, and it’s part of what makes our financial system great. And there are certainly times—post-9/11 being one—when a government backstop is appropriate. But there’s a difference between policymakers getting out of the way and actively partnering with speculators.

Whatever one might call that, “conservative” it’s not. If conservatism is the preservation of things that are intrinsically valuable, what is conservative about policies that destabilize and debase the dollar? One might argue that optimism and upward mobility are also intrinsically valuable and an integral part of America’s national identity. So what does it mean to go down a road that deadends in mass foreclosures and bankruptcies, millions of unsold homes on the market, families uprooted, and legions of young, experience-hardened cynics?

On Dec. 6, President Bush announced a Treasury-led plan by the mortgage industry to freeze rates for some subprime borrowers. Not to be outdone, Hillary Clinton came out with a more ambitious proposal. As politicians trip over themselves in an election year to mitigate unpleasant consequences, the rest of the world will no doubt be watching nervously. It’s ironic that a rediscovery of the intrinsically valuable might be forced on us by foreigners. As holders of dollar-denominated assets, they have a keen understanding of moral hazard and the role of the nanny state. That might not matter in a less interdependent world. But since U.S. dollars are the world’s de facto reserve currency, foreigners have a vested interest in the dollar’s value.

The rising tension is unmistakable. On Nov. 7, Xu Jian, a vice director of China’s central bank, said the dollar is “losing its status as the world currency.’’ On the same day, Cheng Siwei, vice chairman of China’s national parliament, said, “We will favor stronger currencies over weaker ones, and will re-adjust accordingly.” In fact, that readjustment has been underway for some time. In August, holdings of U.S. bonds by foreign governments at the Federal Reserve fell 3.8 percent, the largest decline since 1992.

Ominously, the largest oil producers have also made their feelings clear. In July, Iran demanded that Japan pay for oil in yen instead of dollars. At the OPEC summit in November, Hugo Chavez claimed, “the dollar has been in free-fall without a parachute.” Venezuela began aggressively moving its foreign currency reserves into euros in 2006. Russia and Indonesia have been doing the same. Since these countries have the gall to question an arrangement in which they accept depreciating paper for their main (and finite) natural resource, they both complicate and profit from the Fed’s efforts to stem economic weakness.

The relationship between oil and the dollar is paramount, for oil is our Achilles heel. Owning all the oil on the planet would free us of a major constraint on monetary policy. Unpleasant and politically inconvenient economic downturns could be avoided, interest rates could stay low longer, the stock and housing markets could rise unfettered, and the nanny state could respond to every inconvenient consequence with freshly printed handouts. But that’s not the case, and policies that assume otherwise have put us up against some immutable economic and geopolitical realities. It wasn’t a coincidence that those two headlines about gas prices and the Fed appeared on the same day in November. They were really about the same underlying story.

Assume everyone in your town requires an increasing number of widgets. You’re in an enviable position: you have the town’s only widget-making machine. But your machine is old and past its peak, and you’re having trouble meeting the demand. You’ve had an informal arrangement with your neighbor for many years. He has a machine that produces pieces of paper embossed with the phrase “Good For One Widget.” Unlike your machine, however, his never breaks down. This arrangement has generally been acceptable to the people who live in the town; they like the way the “Good For One Widget” pieces of paper look, and they get their widgets when they need them.

Over the past few years, your neighbor has married, started a family, remodeled his house, and grown fond of taking expensive vacations. To pay for all that and meet his own need for an ever increasing amount of widgets, he builds several more “Good For One Widget” machines and runs them nonstop, day and night. You’ve also started a family and have your own responsibilities. You wish your machine ran as well as his, and you’re starting to worry about what will happen when yours stops running completely and you still have a family to support.

One day your neighbor calls you, complains that the unreliability of your widget machine is affecting him, and demands that you get it running better to meet the rapidly increasing production of his machine. You realize you have a decision to make: try to squeeze as many widgets as possible out of the remaining life of your machine and accept the same amount of paper in return, or let the price of your widgets rise to earn as much as you can while you still have the ability to produce them at all. If you’re the widget maker, what’s the best choice?

Now assume you own the “Good For One Widget” machine, and your name is Ben Bernanke. Your widget-producing neighbor’s name is Abdullah. Does that change your answer?

This is where the rubber meets the road in the great game. It’s where bridges to nowhere, Twilight Zone economic statistics, market intervention and bailouts, wars via national credit card, an open-ended occupation, and a Fed official’s lofty promise to Milton Friedman are all called to account. Everything about Washington is the art of the possible: whatever can be done is done, until it can’t be done any longer. But we cannot print oil. And to the extent we’ve entered an age in which most wars will be fought not over religion or ethnicity but over natural resources, that has dire implications, as much for those who happen to live above the oil, tragically, as for us.

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Wilson Burman is the pen name for a New York City financial executive who writes The Cunning Realist blog.